Fed faces tough inflation framework by Reuters

By Ann Saphir and Howard Schneider

PALO ALTO, Calif. (Reuters) – Federal Reserve policymakers fear being ill-equipped to face the next recession as part of their current inflation targeting strategy, and are embarking this year on a an effort to define new interest rate management strategies around the world. moderate inflation and low borrowing costs.

But for central bankers and US monetary policy experts who met Friday in Palo Alto to discuss the options available, the challenge was clear: not only will it be difficult to define a better framework before the next recession and determine how to explain it. to the public so that it really works will be a major challenge.

Indeed, just to explain their ideas to each other, policy makers and academics at the Hoover Institution's annual conference posted slide after slide, filled with equations, long dots and almost indecipherable graphics.

And while most economists with PhDs in the audience likely understood theories, "I think that where people disagree, are the model's assumptions actually true in real life? ? " President of the Cleveland Fed Bank, Loretta Mester, said in an interview on the sidelines of the conference.

In other words, what will really work?

When central banks around the world turned to unconventional tools such as bond buying and forward-looking guidance to combat the 2007-2009 financial crisis, they thought they faced unique conditions .

But ten years after the end of the Great Recession, it is clear that the Fed faces a new economic norm. Neither inflation nor interest rates should increase significantly, even if the US unemployment rate is at its lowest level in 50 years.

This leaves the central bank with much less leeway to reduce interest rates to stimulate the economy in the past.

This year, while the US economy is at a standstill, interest rate policy is on hold and the expansion is expected to reach a record length this summer, Fed policymakers believe they have some margin of to find a way to make policy more effective. the next recession where the shock comes.

Among the ideas: to commit to offsetting periods of low inflation with periods of higher inflation than the goal; target economic output rather than inflation directly; and use negative interest rates to force companies to invest and banks to lend in times of economic downturn.

SHOCK ABSORBERS FOR A NEW WORLD

According to their advocates, all would act as buffers to alleviate economic weakness and shorten recessions.

Each would be different, to varying degrees, from the current approach of the Fed, which aims for inflation of 2% and an ill-defined ideal of full employment.

And everything would critically depend on the understanding of the framework by households, businesses and financial markets and their response accordingly.

The average targeting of inflation is the framework option that has garnered the most support so far. The idea, said New York Fed Chairman John Williams (NYSE :), is to aim for an average inflation of 2% over a given period, say a year and a half.

When inflation declines in times of economic stress, the central bank reacts by maintaining an easy policy until inflation exceeds 2% and stays there for a while.

If households and businesses know that they can count on higher inflation in the future, they will borrow and spend more during recessions, which in theory would accelerate the return to health of the economy. economy. But for the plan to work, investors will have to believe that the Fed will actually increase inflation in the future.

On the other hand, negative rates would stimulate the economy by punishing companies that do not put money into the economy; If they keep their money in the bank, they will pay for the privilege. For such a scheme to be accepted, however, ordinary citizens must be sure not to be punished equally.

Fed policymakers have largely rejected negative rates, but some central banks have tried it and academics like Kenneth Rogoff, a professor at Harvard University, who presented his work at the Hoover conference , claim that this option is viable.

Not all conference attendees were convinced of the benefits of a new framework, not even the Fed's decision makers who presented some of the ideas.

"The bar is high for change," said Mary Daly, head of the Fed in San Francisco, "it can be expensive to make mistakes in this space."

The head of the St. Louis Fed, James Bullard, has long advocated a framework called nominal GDP targeting, in which the Fed would target a specific level of economic output rather than prices directly.

But even if he gave a new impetus to the idea, he expressed his concern with such a radical change: to experience the way the world's largest central bank does business could, he said, "unleash chaos" over global financial markets.

One of the challenges of selling a new framework is that, in the last 10 years, central banks around the world have failed to meet their current inflation targets of 2 %, the international standard in force.

For Mester of the Cleveland Fed, having a set of rules, no matter what they are, could make the policy more effective by facilitating understanding of the goals and limits of the Fed's actions.

And Fed decision makers in Palo Alto seemed to want to explore new ideas. The Fed has organized a half dozen additional events around the revised framework planned for the rest of the year.

Most viewers acknowledged that the Fed had the merit of tackling the problem. Andy Levin, professor of economics at Dartmouth College, "The Fed must find something new."